King: No 'kickstart' for British mortgage lending

BOE chief warns hitting inflation target won't be 'straightforward'

By

WilliamL. Watts

LONDON (MarketWatch) -- The special liquidity plan unveiled by the Bank of England last week isn't designed to "kickstart" sluggish mortgage lending, but instead aims to ensure banks are confident they will be repaid when lending to each other, Bank of England Gov. Mervyn King said Tuesday.

Testifying before a parliamentary hearing on his appointment to a second, five-year term at the helm of the central bank, King, responding to a question, said a return to recent mortgage-lending practices would be a "mistake."

Data released by the Bank of England earlier showed that new mortgage approvals fell to 64,000 in March from 72,000 in February -- the lowest level since the current statistical series began in 1999.

The plan, dubbed the "special liquidity scheme," allows banks to swap certain, hard-to-move but highly-rated mortgage-backed securities for U.K. treasury notes for up to a year. The Bank of England charges a fee and imposes a significant "haircut" on the value of the mortgage-backed securities. The banks can then use the treasury notes for collateral as they seek loans from other banks.

The move came in a bid to thaw frozen credit markets in the wake of the global credit crunch. See full story.

In a written reply to a questionnaire from the committee, King noted that the financial sector "is reducing the size of balance sheets by cutting back on lending and raising new capital."

"That is not a process we can, or should try to, stop," he wrote.

Following the hearing, the Treasury Committee said it had unanimously backed the government's decision to appoint King to a second term.

"In order to avoid market uncertainty, I am announcing today with the Treasury Committee's agreement that the report to be published next week unanimously endorses the Governor's re-appointment for a second term," said the panel chairman John McFall, in a written statement.

King warned during the hearing that hitting the central bank's 2% inflation target would present a challenge for the rate-setting Monetary Policy Committee.

"That is unlikely to be straightforward," King said, as the panel wrestles with the challenge presented by a sharp rise in oil and other energy prices that can push overall inflation away from the target.

King told lawmakers that inflation is likely to exceed 3% in 2008 and could remain above that level longer than was the case in 2007. The bank is required to write a letter of explanation to the government if inflation rises above 3%.

"The MPC will need to ensure that these deviations are temporary so that they have minimal impact on the expectations of those setting pay and prices," King wrote. "This will not be the last time it faces a balancing act between avoiding unnecessary volatility in economic activity and avoiding any tendency for deviations of inflation from the target to persist."

The MPC, which has cut the official bank rate three times since December to 5%, faces a tough balancing act in setting interest rates, King said.

Policymakers must balance the risk of a sharp slowdown in activity that would pull inflation below target with the risk that above-target inflation in the short term could prove persistent, King said.

King said he was encouraged by signs that inflation pressures haven't translated into higher wage settlements, but said he couldn't assume that future wage deals wouldn't be impacted by inflation expectations.

And he repeated the MPC's expectations that consumer spending will slow and the economy will see growth below trend in the next year or two.

Economists said the data and the testimony underscored expectations for further but gradual interest-rate cuts by the Bank of England.

"We continue to expect the MPC to cut rates a lot further over time as clear evidence of marked economic weakness comes through," said Michael Saunders, an economist with Citi. "But, with rising inflation and high inflation expectations - over which the governor highlighted his concern - easing will remain gradual."

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